Stock Market: The Great Collapse Back to Reality Begins

By Michael Lombardi, MBA Published : January 30, 2014

“The trade” was very easy to do not long ago. Anyone with the basic knowledge of how money flows could have done it and profited.

Of course, I’m talking about the Federal Reserve “trade.” The investment strategy was straightforward: borrow money at low interest rates in the U.S., then invest the money for higher returns in emerging markets and bank the difference. If you could borrow money at three percent per annum in the U.S. and invest it for a six-percent return in emerging markets like India, why wouldn’t you?

The “trade” created a rush to emerging markets. And if you didn’t like the emerging markets, you could have invested in the stock market right here in the good old U.S.A. Again, borrowing money at a low rate to buy stocks from companies that were buying back their own stocks at the same time the Fed flooded the system with cold hard cash…how could you go wrong? (No wonder the rich got richer during the Fed’s quantitative easing programs.)

But, as I have written so many times, parties can only last for so long. Eventually, someone takes away the punch bowl. And from the looks of it, the Federal Reserve has pulled its own punch bowl.

In its statement yesterday after its two-day meeting, the Federal Reserve said, “…the Committee (has) decided to make a further measured reduction in the pace of its asset purchases…” (Source: Federal Reserve, January 29, 2014.)

In summary, the Federal Reserve will be buying $65.0 billion worth of bonds in February following its reduced $75.0 billion in purchases in January following its $85.0 billion-a-month bond buying in 2013.

The pullback on the Fed’s money printing, or what it refers to as “tapering,” is having its long-expected impact on stock prices—they’re falling like a rock. The Dow Jones Industrial Average is down a massive 830 points (five percent) so far this year, gold (unexpectedly) is rising, and emerging markets are crashing.

No matter where you look in the emerging markets economies, you will see increasing selling pressures on their stock markets. Why? As the greenback gets stronger each time the Fed pulls back on money printing, the currencies of emerging markets are falling and their respective stock markets are reacting accordingly (also falling).

For instance, look at the chart below of the South African rand compared to a basket of major currencies. It has declined almost five percent since the beginning of the year.

Chart courtesy of www.StockCharts.com

To fight the currency decline and support the African rand, the central bank of South Africa has raised interest rates for the first time in almost six years. The central bank said this decision was made because it expected further pressures on the currency. (Source: Reuters, January 29, 2014.)

Of course, when interest rates rise in a country, the stock market falls because: 1) public companies have higher borrowing costs; 2) investors move out of risky stocks and into government bonds that are all of a sudden paying higher interest rates; and 3) consumers pull back on spending, thus reducing revenue at public companies.

Turkey is in a very similar situation. The central bank of that country has taken some extreme measures to keep investors in the country…boosting interest rates significantly…pushing their overnight borrowing rate from 3.5% to eight percent!

The central bank of Turkey said, “Recent domestic and external developments are having an adverse impact on risk perceptions, leading to a significant depreciation in the Turkish lira and a pronounced increase in the risk premium.” (Source: “Decision of the Monetary Policy Committee,” Central Bank of the Republic of Turkey, January 28, 2014.) Hence, they boosted rates to support their currency.

Russia is going through a similar phase. Their currency, the ruble, has collapsed to multiyear lows.

As emerging markets witness a sell-off prompted by a sudden increase in borrowing costs, key stock indices here in the U.S. economy are selling off too. The “trade” seems to be ending here as well. January’s return for the S&P 500 now looks like it could be the worst since January 2002! Not knowing what to do, investors are doing the old “flight to safety” thing, moving back into safer assets like gold.

What’s been the best investment performer so far this year? Well, if it isn’t the gold sector. The Market Vectors Gold Miners ETF (NYSEArca/GDX) is up 10% for January.

Dear reader, in the second half of 2013, I really turned on the “heat,” warning about our overbought stock market; it became a bubble again and many times, I warned that bubble would burst. The “Great 2014 Decline” in stock prices I predicted has begun. So far, the collapse (830 points on the Dow Jones in less than a month) has been relentless.

Unfortunately, I don’t see the pace of the decline in stock prices ending anytime soon. Stocks are still very, very overpriced.